Advantages of ABC costing technique
Activity based costing is a costing model and technique which helps in the allocation of the indirect costs in the companies and industries to different processes. The allocation of direct costs and expenses is relatively easy as the same is directly allocated in the ratio of sales made by company. However, it is just the indirect costs which poses a problem and hence a suitable cost driver needs to be defined based on which allocation can be done. As per the activity based costing methodology, the total cost pool is allocated to the different activities, which is further allocated to given cost centres based on the nature and finally the costs are then distributed based on the cost drivers. Cost drivers are nothing but the allocation base which helps in dividing the cost. It gives per unit cost for each given activity (Boccia & Leonardi, 2016). As per ABC logic relationship must be established between the activity and the costs. Like, rent is allocated to different activities based on the space occupied, electricity is allocated to different activities based on the machine hours being used. Cost can generally be divided in 3 categories namely the fixed costs, the variable costs and the semi variable costs. ABC costing thus helps in allocating various types of costs effectively and efficiently and thus utilization of limited resources in the best possible manner.
There are various advantages of Activity Based Costing, some of which are mentioned below:
- For a manufacturing as well as the service industry, ABC costing techniques is very crucial as it helps in allocating the correct costs to the different activities and thus helping in accurate pricing of the products otherwise it might result in higher costs for few product lines and lower costs for few another making it difficult for the company to do the product wise profitability analysis(Choy, 2018).
- It is one of the best ways to find out the inefficient and repetitive activities or activities which are simply non-productive. The same can just be eliminated after due evaluation and it would help the company in cutting down the costs and increasing efficiency of operations. Alternatively, the same can be outsourced as well in case the company finds it cheap.
- ABC costing as well as time driven costing both were evolved to give the accurate and correct cost allocation and logic for the allocation keys. They give the standards key for correct costing of the different products in the company’s product line.
- With the help of this techniques, correct profit margins can be calculated and that can help the company in understanding what the manufacturing overheads that can be curtailed are and the profitability can thus be increased(Cheatham & Cheatham, 1996).
Besides advantages, there are several shortcomings and disadvantages being posed by ABC costing technique, some of which are listed below:
- For the small companies, this may be a difficult process to implement considering the costs and the expertise that is involved. In the small companies the cost base as lower as the number of products and the cost heads is also lower, in which the traditional costing may be used as ABC costing would not make much of a difference.
- In case, if the manager’s performance is linked to the results of the activity based costing, the same may give drastically different results as compared to traditional methods and that may lead to conflict between the parties(Delone & Mclean, 2004).
- ABC costing is rendered useless if proper time is not devoted and the input data is incorrect or inaccurate. Therefore, for proper results, correct base data and a lot of times is involved.
- Since ABC costing is a non-standardised process, therefore the management needs to prepare a separate cost report which is in line with the Generally Accepted Accounting Principles. Thus, it leads to addition in efforts and time required.
- For operating ABC costing technique in the company, the person should have expertise in costing terms like the cost drivers, cost pools, allocation logic, etc., and the in-depth knowledge of the operations and nature of the company, so this is also one of the bottlenecks in implementing the same(Werner, 2017).
The two journal articles which have bene studied and analysed here are “The Measurement and Management of Unused Capacity in a Time Driven Activity Based Costing System” by Veyis Naci Tanis and Hasan Özyapici and “The Value of Activity-Based Costing in Competitive Pricing Decisions” by Eddy Cardinals; Filip Roodhooft, and Warlop Luk. The conclusions and recommendation has been derived at basis these articles only.
The 1st journal paper basically emphasized on the effectiveness of the activity based costing especially in the manufacturing industry and how this techniques helps in the correct and accurate pricing of the goods (Dan, 1995). It reveals that the activity based costing is much effective way of allocation of costs as compared to the traditional costing methods and the volume based costing techniques. It aims to remove the inefficient activities and thus getting over the competitor’s pricing model. But what if all the companies are using it? There comes the concept of Time driven activity based costing which is even more accurate method of cost allocation. The same has been discussed extensively in the 2nd case study.
The purpose of the 1st research journal is to determine the importance and significance of ABC costing technique when the complete information is not available on all the factors and still the price of the product needs to determine. Due to the increasing competition, it has become very difficult to price the product and the market information or the costing plays very negligible role in determining the pricing of the product. The market feedback on the product generally superseded the accounting calculation for pricing and it has been observed and studied that the product which is dealing in multimarket and where the pricing techniques is based on old traditional methods then it may give wrong results due to under allocation or over allocation of the costs (Eddy, Filip,R, & Warlop, 2004). This results in wrong pricing of the products and the one which should have been profitable in the marketplace does actually show losses. It was studied in 1999 by Briers et al. that the biased methods of costing and the base data led to the pricing decision which were effective only when the same was coupled with market feedback and only when there was no direct competition being involved. During this period, ABC costing was not being tested. However, later on 2 hypotheses were assumed in the experimental market conditions and the testing was being done (Baker, 1989). The 1st hypothesis being the prices as well as the profits are maximised and optimized when there is informative feedback from market rather than the uninformative market feedback. The 2nd assumption was benefits of ABC costing technique fall as compared to the traditional technique when the data from market is more informative.
Disadvantages of ABC costing technique
To test the above hypothetical scenario, 131 management graduates and cost scholars and cost accounting qualified students were chosen and they were being asked to divide and allocate the given set of costs based on traditional costing method and the ABC costing method. In the ABC costing technique scenario, the costs relating to the customer were divided based on the 3 activities namely delivery, ordering and the software handling time and space for the orders. Based on ABC technique, the cost was then divided based on cost drivers like no. of deliveries, orders and software handling time. The results were calculated, evaluated and the process was to check the profitability across 10 different time periods and if the new process was robust enough to accommodate for changes in market information. From the average of first 5 results, it was found that there was minimum relationship between the market feedback and the accounting calculations and it held minimum relevance, thereby proving that the 2nd hypotheses was wrong and companies are operating in a perfectly competitive market, where the information on competitors’ pricing is limited (Meroño-Cerdán, Lopez-Nicolas, & Molina-Castillo, 2017). Thus, it was concluded that Activity based costing is far better method of allocation of costs which has minimum dependence on market parameters and based on most appropriate cost drivers, companies can allocate the given set of indirect costs and it is bound to give appropriate and relevant results for pricing of product. It helps in price fixation and give true result to the management, thereby helping in eliminating inefficient and unproductive activities.
The 2nd case study deals with overcoming the issues which were faced in the activity based costing and a study of how to utilise the unused capacities in the company so that the effectiveness and efficiency of operations can be increased. The answer to that is time driven activity based costing. There are many companies working for 24 hours a day and it might be really difficult for them to evaluate the spare working hours or the unused capacities. So, in order to determine the same, there are 2 concepts namely compulsory and real unused capacities. The aim of this research paper is to further increase the accuracy and effectiveness of the ABC system through the implementation of the revised version named TDABC. In this, the employees are redirected to the productive areas or departments based on per shift basis rather than finding the unused capacity per day and then taking the corrective measures. Companies are nowadays looking for advanced method of costs management as all the above mentioned practices are not possible through the traditional costing methods (Naci & Hasan, 2012). Also, the ABC system or techniques posed the unique problem of selection of the cost drivers within the various departments and there was no standard process within the industry as different companies used different cost drivers and allocation logics. This case study aims to overcome all such issues and standardise the process.
Time Driven activity based costing can be termed as the refined version of the activity based costing and in this process, costs management accountants handling the cost issues should be aware of the total resources existing with the company and the no. of resource units that will be required to complete a given activity. Therefore, there are 2 parameters which are required for implementation of TDABC system – the cost per unit of resources and the number of resources units that will be consumed by a particular customer, activity or process. The benefit of this process would be it will be more accurate and more logical in terms of results and it would also account for the costs which usually gets eliminated or ignored in ABC system. Mathematically, the cost driver is the product of cost per unit of resource and no. of such units required. The cost per unit can be determined if the practical capacity of the resource is known. Suppose, for example, a machine which operates of 40 hours a week can be assumed to have effective capacity of 80-85% which comes out to 32-34 hours a week (Mun, 2018). The main bottleneck here is that the practical and effective capacity should be carefully calculated or else the entire results would be wrong or erroneous. The other variable of number of units required to complete a given activity can be determined by the way of interview through a group of employees or through direct observation methods. It can also be done through employee survey forms as the end purpose is to get the rough estimate and not the exact numbers.
Discussion on the two journals
Though this study it was studied and concluded that the time driven activity based costing was one technique which would not only help the companies in proper cost allocation but also in utilising the unused capacities thereby bringing in economies of scale.
There were many similarities between the 2 case studies, out of which the major ones are listed below:
- Both the techniques were intimated to sort out the problems of cost allocation for indirect costs and finding out the correct cost drivers which can be used as allocation bases. Both these activities made the pricing more logical and competitive thereby leading to correct calculation of the profits per product.
- Both the processes ultimately aim to simplify cost management and time management for the companies and eliminating the inefficient activities thereby also helping in the cost reduction measures(Dichev, 2017).
The difference in the 2 case studies were:
- The first case study always focused on the derivation of the correct cost drivers and the study was based on the traditional costing method and the activity based costing method. It used market information and feedback as one of the parameters for doing the study and research. The 2ndcase study on the other hand, focused on the time management aspect and mentioned that time is the only correct base which is universal among all the cost drivers and thus leads to even better cost allocation techniques (Jefferson, 2017).
- Activity based costing being discussed in the first case study was aimed at pointing out the inefficiencies and issues due to poor resource management and thus finding out the optimum cost drivers to do proper allocation of costs amongst products on the other hand, time driven activity based costing being discussed in the 2ndcase study focused on maximising the efficiency of machines by finding out the unused capacities per shift and driving best utilization of available resources.
It can be said that both the studies are unique in its own way and have shown various advantages and reforms over the previously existing systems. Both the systems have their shortcomings and depending on the convenience the company may opt for the best suitable method for them.
There are various lessons on cost management, time management and cost allocation from the above discussed both the activities and it would be helpful for the cost management accountants in Australia and over the world for increasing profitability and maximising use of resources. Some of the major learnings are:
- New competitors entering into the market place generally follow the existing trend in the market and this is most often the case with the small businesses following the methods used by the market leaders(Fay & Negangard, 2017).
- It was also established that when there is limited market information, then the companies which were using the ABC costing techniques found the market information to be less useful than the other group using the volume based costing techniques.
- The price demand effect which is being set by the market leader is stronger than the cross pricing effect which is being done or initiated by the competitors in the market. This is because the competitors would be hardly left with any demand if the rivals lowers the prices in reaction to cross pricing effect.
- It was also being observed that the pricing of the goods when done using the traditional cost allocation methods, results in prices which are far from optimal prices and is unusually overpriced which makes the accounting profit looks negative. On the contrary when the activity based costing techniques is being used, it leads to optimal pricing and the accounting profit as well as the sales of the product increases.
The key learnings from the 2nd research paper are mentioned below:
- The concept of TDABC overcomes the shortcomings of the traditional and volume based cost allocation methods and helps the companies in determining the practical and effective capacity of the machines, thereby helping in identifying the possible output of company.
- The 2ndcase study also focused on effective utilisation of minimum resources and shifting the manpower to productive areas (Sithole, Chandler, Abeysekera, & Paas, 2017).
- It also highlighted what are the inefficient activities and processes and how the company can get rid of them and thereby increase overall efficiency in operations.
- The TDABC concept is the refinement of the old costing system and leads to standardization among the companies with respect to the allocation keys, thus making the data comparable. With this technique, it becomes easy for the company to make estimates and forecast for the future.
References
Baker, W. (1989). Why traditional standard cost systems are not effective in today’s manufacturing environment. Industrial Management,, 31(4), 22-24.
Boccia, F., & Leonardi, R. (2016). The Challenge of the Digital Economy. Markets, Taxation and Appropriate Economic Models, 1-16.
Calvasina, R. V., & Calvasina, E. J. (2017). Standard Costing Games that Managers Play. Journal of Management Accounting Research, 12(2), 33-65.
Cheatham, C., & Cheatham, L. (1996). Redesigning cost systems: Is standard costing obsolete? Accounting Horizons, 10(4), 23.
Choy, Y. K. (2018). Cost-benefit Analysis, Values, Wellbeing and Ethics: An Indigenous Worldview Analysis. Ecological Economics, 145. Retrieved from https://doi.org/10.1016/j.ecolecon.2017.08.005
Dan, S. (1995). The benefits of activity-based cost management to the manufacturing industry. Journal of Management Accounting Research, 7, 167.
Delone, W., & Mclean, E. (2004). Measuring e-Commerce Success: Applying the DeLone & McLean Information Systems Success Model. International Journal of Electronic Commerce, 9(1).
Dichev, I. (2017). On the conceptual foundations of financial reporting. Accounting and Business Research, 47(6), 617-632. doi:https://doi.org/10.1080/00014788.2017.1299620
Eddy, C., Filip,R, & Warlop, L. (2004). The Value of Activity-Based Costing in Competitive Pricing Decisions. Journal of Management Accounting Research, 16, 133-148.
Fay, R., & Negangard, E. (2017). Manual journal entry testing : Data analytics and the risk of fraud. Journal of Accounting Education, 38, 37-49.
Jefferson, M. (2017). Energy, Complexity and Wealth Maximization, R. Ayres. Springer, Switzerland . Technological Forecasting and Social Change, 353-354.
Meroño-Cerdán, A., Lopez-Nicolas, C., & Molina-Castillo, F. (2017). Risk aversion, innovation and performance in family firms. Economics of Innovation and new technology, 1-15.
Mun, K. a. (2018). A close look at the role of regulatory fit in consumers’ responses to unethical firms.
Naci, T., & Hasan, O. (2012). The Measurement and Management of Unused Capacity in a Time Driven Activity Based Costing System. Journal of Applied Management Accounting Research, 10(2), 43-55.
Sithole, S., Chandler, P., Abeysekera, I., & Paas, F. (2017). Benefits of guided self-management of attention on learning accounting. Journal of Educational Psychology, 109(2), 220. Retrieved from https://psycnet.apa.org/buy/2016-21263-001
Werner, M. (2017). Financial process mining – Accounting data structure dependent control flow inference. International Journal of Accounting Information Systems, 25(1), 57-80.
Order an Essay Now & Get These Features For Free:
Turnitin Report
Formatting
Title Page
Citation
Outline
